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Holy Matrimony! Why Harris Corporation and Exelis Shares Took Off

A Harris Corporation-Exelis tie-up would be the largest defense sector deal since the 1990s.

Although we don't believe in timing the market or panicking over market movements, we do like to keep an eye on big changes -- just in case they're material to our investing thesis.

What: Shares of communications company Harris Corporation(NYSE:HRS) rose as much as 12.9% on Friday as the defense contractor announced it's acquiring Exelis(UNKNOWN:XLS.DL) for approximately $23.75 per share in a cash-and-share deal that values Exelis at $4.4 billion. The deal price represents a 34% premium to Exelis' Thursday closing price; the stock leaped as high as $25 (+46%) on the news.

So what: Today's news has broader implications for the defense sector. The proposed acquisition would be the largest since massive consolidation reshaped the sector in the 1990s, and would make Harris one of the Defense Department's top 10 suppliers. This deal could be the catalyst for another wave of consolidation among mid-size defense contractors -- Harris Corporation itself could be an attractive target in that context, which may partially explain its share-price rise.

Exelis, which was spun out of ITT in 2011, provides command, control, and communications systems, and caters to commercial and military aircraft. In addition to the revenue synergies between their core businesses, Harris expects to achieve pre-tax cost savings of $100 million to $120 million. Capitalizing those savings at Harris' 15.4 forward price-to-earnings multiple, assuming a 33% tax rate, is worth an extra $1.1 billion in market value.

Now what: The Pentagon has indicated that it doesn't want mergers among the top five defense contracts, but Harris CEO Bill Brown told The Wall Street Journal that he expects them to welcome this deal to promote "stability and competition in the industrial base." Brown would like to close the deal in June. The spread between Exelis' current share price and the implied value of Harris' offer suggests the market believes the deal will not encounter any opposition.